How to Choose the Right Index Funds and ETFs

To diversify your investments wisely and simply, answer these three questions

Financial advisers often recommend index funds and their Exchange Traded Fund (ETF) cousins as smart ways to invest, especially as retirement approaches. These low-cost investments are intended to match the performance of major market benchmarks, like the S&P 500. They offer instant diversification and eliminate the risk of choosing a mutual fund whose manager turns in subpar performance, as so many do.

But which index funds and ETFs are best?

Not every index fund or ETF — a stock that tracks a stock index — is appropriate for a small investor’s portfolio. Some have higher fees than others. Certain index funds and ETFs carry extra risks because they’re narrowly focused, tracking stocks of a single industry or country. As a result, they could drop in value far more than the overall market.

Before investing in an index fund or ETF, these are the key questions you’ll want to answer:

Which index should you use? That's a trickier question than you may think, because there are dozens of indexes used by index funds and ETFs. Standard & Poors alone has 10 U.S. equity indexes and nine U.S bond indexes.

Since a key benefit of these instruments is easy diversification, make sure any you choose will work toward that goal.

Start simply: Look for broad-based U.S. stock or bond index funds or ETFs. You can find a list at Bloomberg.com and the ETF area of Morningstar.com. By purchasing a broad-based fund or ETF that owns a wide swath of stocks or funds, your performance will match the overall market, rather than just a piece of it.

If you want to invest internationally, buy a developed-market international fund or ETF, like one based on the MSCI EAFE index (MSCI is the company that created the index; EAFE stands for Europe, Australasia and Far East). Stocks of developed markets are less volatile, typically, than those of undeveloped or underdeveloped regions.

If you’ve covered these bases, you may want to broaden your portfolio to include companies or countries you’re missing or want to weigh more heavily. Chances are, you'll be able to find an index fund or ETF that tracks them. The recent Wall Street Journal article, “So Many Thin Slices, So Hard to Pick the Right One,” has useful advice on choosing among similar ETFs in the same sector.

Brooks Mosley, a financial adviser at Security Ballew Wealth Management in Jackson, Miss., especially likes using index funds to help his clients gain exposure to emerging markets. "Indexes are a great way to participate in another corner of the world without having to be an expert," he says.

Most people, however, should avoid ETFs that are intended to mimic trading strategies, like short-selling or option writing. They’re for sophisticated investors and are more about speculation than long-term, buy-and-hold ownership.

Should you choose an index fund or an ETF? From a cost standpoint, ETFs often offer an advantage over index funds.

Jim Rowley, senior investment analyst at Vanguard, the money management firm that invented indexing, says ETFs generally have smaller expense ratios than funds using the same index. (An expense ratio is the percentage of the investment’s assets paid in fees to the firm’s management.)

For example, Vanguard's High Dividend Yield Index mutual fund, which owns dividend-paying U.S. stocks, has an expense ratio of 0.25 percent; for the High Dividend Yield Index ETF, it's 0.13 percent.

But since ETFs are stocks, they can cost more to purchase than funds because of their brokerage commissions that, on frequent ETF purchases, can soon dwarf the savings of the investment’s lower expense ratio.

In general, ETFs are better for investors who will be making larger, less-frequent purchases (using, for example, a lump sum from an inheritance), while mutual funds are better for people making smaller, frequent purchases (such as those made with monthly contributions to a retirement plan).

Which mutual fund or ETF company should you buy from? Because index funds and ETFs are intended to mirror the performance of their underlying benchmarks, ones based on the same index should have the same performance, before fees. So, all else being equal, when selecting among similar index funds and ETFs, the fund or ETF company with the least expensive version is best.

Since it can be difficult for new index funds and ETFs to attract customers, Mosley prefers dealing with established ones. There’s less chance that the fund or ETF with a long track record will shut down due to a lack of investors.

And that’s not an unlikely possibility. Scottrade, the online brokerage, brought out a series of ETFs in 2011 then announced in September 2012 that it would be closing them. According to The Wall Street Journal, 80 ETFs have been withdrawn from the market since January, due to lack of interest.

When selecting an index fund or ETF, you don't want to find yourself holding one headed for the trash pile. After all, the whole point of these investments is to reduce your financial concerns, not heighten them.